Case #28 JetBlue Airways IPO

Synopsis and Objectives This case examines the April 2002, decision of JetBlue management to price the initial public offering of JetBlue stock during one of the worst periods in airline history. The case outlines JetBlues innovative strategy and the associated strong financial performance over its initial two years. The task is to value the stock and take a position on whether the current $25$26 per share filing range is appropriate. The case is designed to showcase corporate valuation using discounted cash flow and peer-company market multiples. The case provides opportunities for: Review the institutional aspects of the equity issuance transaction. Explore the costs and benefits associated with public share offerings. Develop an appreciation for the challenges of valuing unseasoned firms. Hone corporate valuation skills, particularly using market multiples. Evaluate the received explanations of various finance anomalies, such as the IPO underpricing phenomenon.

Suggested Questions 1. What are the advantages and disadvantages of going public? 2. What different approaches can be used to value JetBlues shares? 3. At what price would you recommend that JetBlue offer their shares?

Pros of multiples: *Convenient *Reflects what the market is willing to pay for a comparable firm *Particularly helpful when firm is not in steady state Cons of multiples: *Ignores need to make explicit assumptions regarding long-term profitability and growth

*Subject to market misvaluation *Subject to accounting distortions *A relative (rather than absolute) valuation measure *Difficulty in identifying comparables *Meaningless with negative values *Denominator may be more cyclical than numerator

JETBLUE AIRWAYS IPO VALUATION Aggregate Pre-IPO Demand for JetBlue Shares

Aggregate Share Demand (Millions of shares)

MM Shares

200 180 160 140 120 100 80 60 40 20 0 4/1/02 4/2/02 4/3/02 4/4/02 4/5/02 4/8/02 4/9/02 4/10/02 4/11/02

Total Shares Offered: Initial Filing Range: Revised Filing Range: Offer Price:

5.9MM $22 - $24 $25 - $26 $27.00

Road show

Offering Size: 5.9 MM Shares

Global Institutions

MS Retail

JETBLUE AIRWAYS IPO VALUATION Share Demand and Allocation Summary

Indication (millions)

Allocation (millions)

Allocation/Indication

Institutions Morgan Stanley retail Merrill Lynch retail Raymond James retail UBS retail Selling Group retail Directed Program (friends and family) Total

144,828 35,000 28,000 2,600 4,000 300 630 215,358

4,819 653 313 165 143 25 605 6,722

3.3% 1.9% 1.1% 6.3% 3.6% 8.3% 96.0% 3.1%

Evidence on IPO Underpricing Winners Curse. Uninformed investors demand rationed for good firms and not for poor firms due to informed investors participation in only good IPOs. Underpricing gives uninformed investors normal return.1 Evidence: In countries where share allocation is transparent (e.g., Singapore and Finland) investors receive more shares of overpriced offerings such that average profits are zero.2 Monopsony. Small number of underwriters following any particular industry allow for potential monopsony profits.3 Evidence: In support, the severe average underpricing of 1980 was concentrated wholly among a few regional underwriters within the petroleum industry.4 Against support, underwriters that take themselves public tend to underprice themselves.5 Lawsuit Avoidance. To avoid litigation for misrepresenting stock to shareholders, firms/underwriters discount initial price. Evidence: In support, offerings before the Securities Act of 1933 (which holds companies responsible for misrepresentation) tend to be less underpriced than offerings after 1933.6 However, firms that are sued following their IPO tend to be just as underpriced as firms that are not sued.7 Reputation. Firms better able to access capital markets in future if leave a good taste in investors mouth.8

Kevin Rock, Why New Issues Are Underpriced, Journal of Financial Economics, 15 (1986), 187-

212. Francis Koh and Terry Walter, A Direct Test of Rock's Model of the Pricing of Unseasoned Issues, Journal of Financial Economics, 23 (1989), 251-272; and Matti Keloharju, The Winner's Curse, Legal Liability, and the Long-Run Price Performance of Initial Public Offerings in Finland, Journal of Financial Economics, 34 (1993), 251-277. 3 David Baron, A Model of the Demand for Investment Banking Advice and Distribution Services for New Issues, Journal of Finance, 37 (1982), 955-976. 4 Jay Ritter, The Hot Issue Market of 1980, Journal of Business, 57 (1984), 215-240. 5 Chris Muscarella and Michael Vetsuypens, A Simple Test of Barons's Model of IPO Underpricing, Journal of Financial Economics, 24 (1989), 125-135. 6 Seha Tinic, Anatomy of Initial Public Offerings of Common Stock, Journal of Finance, 43 (1988), 789-822. 7 Philip Drake and Michael Vetsuypens, IPO Underpricing and Insurance Against Legal Liability , Financial Management, 22 (1993), 64-73. 8 Franklin Allen and Gerald Faulhaber, Signaling by Underpricing in the IPO Market , Journal of Financial Economics, 23 (1989), 303-323; Thomas Chemmanur, The Pricing of IPOs: A Dynamic Model With Information Production, Journal of Finance, 48 (1993), 285-304; Mark Grinblatt and Chuan-Yang Hwang, Signaling and the Pricing of New Issues, Journal of Finance, 44 (1989), 393-420; and Ivo Welch, Seasoned Offerings, Imitation Costs and the Underwriting of IPOs, Journal of Finance 44 (1989), 421449.
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Evidence: Little empirical support has been found for a relationship between underpricing and subsequent offerings.9 Censored distribution. Underwriters correctly price on average, but stock stabilization efforts remove the left-hand side of non-stabilized first-day distribution of returns leading to average positive performance. Evidence: A disproportionate number of IPOs have first-day returns of zero. IPOs with first-day returns of zero tend to experience negative returns over first month, suggesting they are temporarily held above their true value.10 Bandwagon. If investors pay attention to IPO demand of other investors, bandwagon effects can create excessive demand for some offerings.11

Narasimhan Jegadeesh, Mark Weinstein, and Ivo Welch, An Empirical Investigation of IPO Returns and Subsequent Equity Offerings, Journal of Financial Economics, 34 (1990), 153-176; and Roni Michaely and Wayne Shaw, The Pricing of Initial Public Offerings: Tests of A dverse Selection and Signaling Theories, Review of Financial Studies, 7 (1994), 279-313. 10 Judith Ruud, Underwriter Price Support and the IPO Underpricing Puzzle , Journal of Financial Economics, 34 (1993), 135-151. 11 Ivo Welch, Sequential Sales, Learning, and Cascades, Journal of Finance, 47 (1992), 695-732.